Who cares about volatility? You should.

Volatility: How Should Investors Think About It, and Act?

Market commentators constantly harp on “volatility” – volatility is rising, volatility is falling, investors need to manage against it – but the concept does not resonate with many retail investors.

Who cares about volatility? You should.

Why should they care? Because most of them want to do some research, consult their financial advisers, then make investment decisions they can pursue with conviction: buy and hold. They do not want to track their portfolios every day. And yet, investors often have to watch as the value of their well-chosen investments suddenly plunge, through no fault or action of theirs.

Market professionals may have triggered a sell-off owing to whatever shocks the media is touting that week: U.S. elections, Brexit, Greece, the ever-ominous “fears from China.” Or stocks may rise or fall dramatically for reasons no one fully understands; that happens a lot.
 

Volatility keeps investors on their toes.

This is volatility: markets move, often daily, sometimes a little, other times a lot, and not always in predictable ways. “Timing the market” is extremely difficult. Fortunately, Legg Mason can help investors understand how volatility can hurt them, and plan ahead to potentially help minimize its impact.

Despite surging in early 2016, U.S. equity market volatility – defined as the amount of uncertainty or risk about the size of changes in a given security's value – nose-dived during the summer. It rose in September, but from very low levels, according to the VIX. (VIX is a trademarked ticker symbol for the CBOE Volatility Index, often referred to as the “fear index.”) Since September 9, intra-day moves of the S&P 500 have more than doubled, a significant move.
 

VIX Index: September 23, 2014 - September 23, 2016

 

The VIX remains around 15 percent, well below historical averages, which for the last 10 years have averaged 20 percent. Volatility progression has been less steady than episodic, with peaks and valleys: low volume followed by high volume followed by low.

Visceral fears of this “fear index” appear to be rising. History shows that investors tend to under-react to information, until they don’t – and then they tend to over-react . It’s classic human behavior. Volatility is mean reverting. It will rise again, although it is difficult to know exactly when. The key question is whether the recent pick-up represents tremors before a major earthquake, or will things settle down, again? What kind of things drive increases in volatility?

Investors may become more sensitive to a host of macro- and microeconomic factors, including real (and sometimes exaggerated, or imagined) concerns over the U.S. Federal Reserve, other central banks , U.S. elections, slowing emerging market growth (especially in China), European Union (in)stability, the health of banks in Germany, Italy and elsewhere, and terrorist events.


In the face of so many possible sources of increasing volatility, what should savvy investors do?

Legg Mason suggests considering an approach that focuses on high-quality global equity investments that have the potential to remain attractive, even in turbulent market environments. When higher volatility looms, investors often want to decrease their market risk. Consider:

  • Sustainable Income Potential:  Includes historically strong dividend paying equities
  • High Quality Assets: Generally have the potential to maintain value and stability across market cycles
  • Low Volatility Assets: Specifically designed for low correlations to market swings
  • Relatively Cheaper Assets: Attractive valuations can indicate room to bounce back
  • Anything with Solid Growth Potential: May continue to rise in the face of headwinds

Combining these options can lead to greater portfolio diversification, which usually is a compelling way to seek to manage risk against unforeseen equity market shocks: try not to be too concentrated in any one direction.

As for fixed income, global bond yields have fallen to record lows at the same time as most developed equity markets hit new highs. Many investors are worried that bonds have lost their diversifying qualities, but bonds have shown over time that they can be solid hedges to equity market risk. Investors should consider alternative hedging strategies away from traditional bond beta, pursuing a multitude of diversification strategies to reach their investment goals.

Many of the best values can be found in emerging markets and sectors like corporate and high yield debt – places where it is important to know where and how to look for value and yield. When volatility rises, experienced, professional asset managers can deliver value though active management, capturing diverse upside opportunities while managing against downside risk. Investors may want to consider unconstrained bond products not tied to specific benchmarks.

In it for the long haul.

While trying to meet their goals, investors should consider staying in the markets for the long term, through good times and bad.  Unfortunately, investors have a tendency to sell out at the worst possible time, usually when the market hits bottom. When they do, the damage can be substantial. Worse, they may never want – or be able – to get back in again.  Investors can be best served by portfolios positioned to meet their objectives, regardless of market moves.  Luckily, there are many ways to position their portfolios today to make staying invested during volatile markets easier down the road.

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